Manufacturers Hanover Trust Co. v. Drysdale Securities Corp.

• Decision Date: 08 September 1986
• Docket Number: Nos. 794,D,858 and 795,s. 794
• Citation: Manufacturers Hanover Trust Co. v. Drysdale Securities Corp., 801 F.2d 13 (2nd Cir. 1986)
• Parties: , Fed. Sec. L. Rep. P 92,902 MANUFACTURERS HANOVER TRUST COMPANY, Plaintiff-Appellee and Cross-Appellant, v. DRYSDALE SECURITIES CORPORATION; Drysdale Government Securities, Inc.; BMC Acquisition Corp., doing business under the name Buttonwood Management; Arthur Andersen & Co.; David J. Heuwetter; Joseph V. Ossorio; and Peter J. Wasserman, Defendants, Appeal of ARTHUR ANDERSEN & CO., Defendant-Appellant and Cross-Appellee. ockets 85-7827, 85-7865 and 85-7929.
• Court: U.S. Court of Appeals — Second Circuit

Page 13

801 F.2d 13

55 USLW 2160, Fed. Sec. L. Rep. P 92,902

MANUFACTURERS HANOVER TRUST COMPANY, Plaintiff-Appellee and Cross-Appellant, v. DRYSDALE SECURITIES CORPORATION; Drysdale Government Securities, Inc.; BMC Acquisition Corp., doing business under the name Buttonwood Management; Arthur Andersen &amp Co.; David J. Heuwetter; Joseph V. Ossorio; and Peter J Wasserman, Defendants Appeal of ARTHUR ANDERSEN & CO., Defendant-Appellant and Cross-Appellee.

Nos. 794, 858 and 795, Dockets 85-7827, 85-7865 and 85-7929.

United States Court of Appeals Second Circuit.

Argued March 17, 1986.

Decided Sept. 8, 1986.

Barry R. Ostrager, New York City (John J. Kerr, Jr., Mark G. Cunha, David W. Sussman, Simpson, Thacher & Bartlett, New York City, of counsel), for plaintiff-appellee and cross-appellant.

Robert L. King, New York City (Martin Frederic Evans, Michael E. Wiles, Edwin G. Schallert, William F. Haigney, Debevoise & Plimpton, New York City, Charles W. Boand, Wilson & McIlvaine, Chicago, Ill., of counsel), for defendant-appellant and cross-appellee.

(Daniel L. Goelzer, Gen. Counsel, Jacob H. Stillman, Associate Gen. Counsel, Rosalind C. Cohen, Asst. Gen. Counsel Richard A. Levine, Atty., Paul Gonson, Sol., Washington, D.C., of counsel), for amicus curiae S.E.C.

Before PIERCE, MINER and ALTIMARI, Circuit Judges.

PIERCE, Circuit Judge:

The defendant accounting firm appeals from a judgment entered in the United States District Court for the Southern District of New York, Richard Owen, Judge, after a jury returned a verdict against it. The jury awarded plaintiff $17 million, to which the district judge added pre-judgment interest, post-judgment interest and costs, in a civil action seeking damages for losses that Manufacturers Hanover Trust Company ("Manufacturers" or "MHT") claimed to have suffered as a result of certain alleged misrepresentations that Arthur Andersen & Co. ("Andersen") made on behalf of Andersen's client, Drysdale Securities Corporation ("DSC") and its successor, Drysdale Government Securities, Inc. ("DGSI"). The district judge submitted seven separate theories of liability to the jury: misrepresentation or material omission "in connection with" the purchase or sale of securities, in violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78j(b), and Rule 10b-5, 17 C.F.R. Sec. 240.10b-5, promulgated thereunder; misrepresentation or material omission "in" the purchase or sale of securities, in violation of section 17(a) of the Securities Act of 1933, 15 U.S.C. Sec. 77q(a)(2); misrepresentation or material omission in a "prospectus" or "oral communication," in violation of section 12(2) of the Securities Act of 1933, 15 U.S.C. Sec. 77l(2); conspiracy to violate the above federal securities laws; aiding and abetting in the violation of the above federal securities laws; common law negligence; and common law fraud. The jury returned a general verdict, following which the judge requested that the jury state the cause or causes of action on which the verdict was premised, which it did.

On appeal, Andersen argues principally that the district court lacked federal subject matter jurisdiction; that the requisite loss causation standard for liability for securities fraud was not met; that plaintiff MHT caused its loss by its own recklessness; that it was error for the district judge to submit a negligence theory to the jury; that in selecting and instructing the jury the district judge deprived Andersen of a fundamentally fair trial; and that reversal of any of MHT's claims requires reversal of the entire verdict. MHT cross-appeals for a mini-trial exclusively on the issue of punitive damages. We affirm the judgment in favor of plaintiff in the amount of $17 million and deny the relief requested on cross-appeal. We also remand for further proceedings on the issue of pre-judgment interest only.

BACKGROUND

In this civil action MHT sought damages against the Andersen accounting firm, which it asserts made misrepresentations as to the financial status of DGSI, a company created by DSC to transact business through trading in repurchase agreements ("repos") or resale agreements ("reverse repos") involving government securities. ¹ DSC, a brokerage house since 1889, engaged in a scheme to purchase and sell government securities through repos and reverse repos beginning in May 1980 and ending in May 1982, just three months after DSC had transfered the repo business to a separate, newly capitalized, corporation called DGSI. The appellees presented evidence to the jury that Warren Essner, a senior Andersen audit partner, misrepresented DGSI's net worth as $20.8 million when it actually was negative $190 million.

DSC had transferred the repo business to DGSI in February 1982 for two related reasons. First, it wanted to satisfy banks that had been serving as DSC agents (acting for an undisclosed principal) and that had begun to demand that DSC provide adequate assurances of sufficient capital to absorb the risk of insolvency in the repo market. Evidence was introduced showing that beginning in December 1981, DSC received requests for an audited financial statement from Chase Manhattan Bank, Chemical Bank, U.S. Trust Co., and MHT. Second, DSC wanted to avoid a New York Stock Exchange audit of DSC repo capitalization. The concerns for DSC's financial stability developed as DSC began to lose money because of financial losses in its securities trading and alleged misappropriation of monies by DSC Chairman Joseph Ossorio and DSC trader David Heuwetter. ²

The mechanics of DGSI's repo business are not disputed. Ossorio and Heuwetter created a so-called "Ponzi" scheme that profited from the use of coupon interest on securities sold. The essence of the scheme was DGSI's exploitation of an important difference between government securities transactions in (1) the "securities" or "cash" market, in which securities are straight-forwardly purchased and sold at market prices, and (2) the "repo market," in which government securities are purchased and sold pursuant to repo or reverse repo transactions. In the securities market, the price of a government security, such as a United States Treasury note, includes the market price of a particular issue and the accrued "coupon interest" on the security (i.e., the value of government payments due on the security at the time of the sale). In the repo market, the accrued coupon interest is paid only on the repurchase (or resale) transaction; the initial "loan" of the security is made at a price that includes only the market value of the security. Before the security is repurchased, its price will be "marked to market" periodically to reflect changed value. By borrowing increasing volumes of government bonds through reverse repos, selling them in the cash market and utilizing the cash and temporarily obtained accrued coupon interest to meet obligations on previously borrowed bonds and to conduct other trades, DGSI managed to stay solvent between February 1, 1982 (when DGSI was created, with the liabilities it had inherited from DSC) and May 17, 1982, when DGSI's ultimate collapse occurred and investors lost some $300 million.

Unlike Ossorio and Heuwetter, Warren Essner, a partner at Andersen, and Andersen itself, were not principals in this scheme. There is no evidence that they profited from it, or that they stood to gain anything from DGSI's precarious situation. Rather, Essner and Andersen had a limited role relating to the creation of DGSI. The fundamental issue in this case involves the scope of liability that flowed from this limited role.

Andersen had audited DSC in 1977 and 1978, but had no business relationship with it again until January 8, 1982. On that date, Ossorio contacted Essner at the Andersen firm regarding tax and accounting concerns in the contemplated creation of DGSI. Essner and Ossorio drafted a January 31, 1982 letter announcing DGSI's formation and discussing its capitalization. The letter was intended for the benefit of potential DGSI clients and indicated that DSC would transfer $5 million in net assets and liabilities to DGSI. (These assets and liabilities constituted repo and reverse repo positions in DSC's portfolio.) In addition, it stated that Heuwetter would invest $12.8 million and Ossorio $2.7 million, bringing the total capitalization to almost $21 million.

There was evidence that during a meeting on January 31, Heuwetter had cautioned Essner about an $11 billion "matched book" ³ of repos and reverse repos that DSC controller Dennis Ruppert (who later pleaded guilty to state securities fraud charges) had fictitiously manufactured to create in part the purported $5 million transfer of DSC positions to DGSI. The true positions concealed by this false "matched book," Heuwetter testified, could not be disclosed, for fear that "if the dealer community found out the size of the positions that I was playing with ... we would be out of business the next day...."

On the evening of January 31, 1982, Essner prepared a "Statement of Subordinated Debt and Equity" to support the January 31 letter. This document did not disclose the size of the government securities positions transferred from DSC to DGSI. It reflected a purported capitalization of $20.8 million ($5 million net assets and liabilities transferred from DSC plus $15.8 million cash). There was evidence that Essner prepared the statement without consulting DSC's books and records, which, in any event, allegedly had been in incomprehensible disarray.

On and after February 1, Heuwetter delivered copies of the letter and statement to financial institutions including MHT. However, Chase and MHT pressed for an audited financial statement prepared by an independent accounting firm, even though both had been doing business with DGSI since its inception on February 1.

The parties dispute whether Ossorio asked Essner to prepare an audited statement by January 31 or during...